Theme 2: The UK economy: performance and policies Flashcards
What is economic growth
Measure of an increase in real GDP. Referred to as actual economic growth
What is gross domestic product (GDP)
The total value of goods and services produce in a country in one year
What is potential economic growth
Measure of the increase in the productive capacity of an economy. (Movement outwards of PPF)
Define recession
When an economy has two consecutive quarters of negative economic growth
What is the difference between nominal and real GDP
Nominal GDP is simply the money value of all goods and services produced by a country in one year. Real GDP is the nominal GDP adjusted for inflation.
What are purchasing power parities (PPP)
PPPs are used to compare GDP in different countries, and take into account the cost of a ‘basket of goods’ that could be bought in each of the countries being compared.
The PPP exchange rate is the rate that equalises the purchasing power of different currencies by eliminating differences in prices between countries.
What is gross national income (GNI)
Measures income received by a country both domestically (GDP) and via net incomes from overseas
TF… GNI = GDP + (profits from companies operating abroad and income earned from nationals living in foreign countries) - (profits from foreign-owned companies and income earned from foreign nationals living in the country that goes abroad)
Limitations of using GDP to compare living standards between countries and over time
- Difference in population: it is necessary to calculate GDP per capita
- Differences in rates of inflation: real GDPs must be compared
- How much of the output is self-consumed so does not appear as GDP
- Methods of calculation and reliability of data may differ
- Type of spending by government: is money spent on warfare, or on quality of life issues such as education and health?
- Differences in income distribution
- Differences in exchange rate
What is the Easterlin paradox
Research suggests that there is a positive relationship between income and happiness up to a certain level of income.
However, once incomes increase beyond that level, marginal gains in happiness fall (Easterlin paradox).
Define inflation
Inflation is a sustained rise in the general price level.
Define deflation
Deflation is a sustained fall in the general price level
Disinflation
Disinflation is a sustained fall in the rate at which the general price level is rising
How is the rate of inflation measured in the UK?
By changes in the Consumer Price Index (CPI) which is a weighted average of items on which people spend their money.
How is the CPI calculated
The Living Costs and Food survey collects information from a sample of nearly 7000 households in the UK using self-reported diaries of all purchases.
A price survey is undertaken by civil servants, who collect data once a month about changes in the price of the 7000 most commonly used goods and services in a variety of retail outlets.
Weights are assigned to each item the average household buys. The weights reflect the proportion of income spent on each item in the average shopping basket.
The price changes are multiplied by the weights to give a price index.
The CPI does not include housing costs, such as rent payments and mortgage interest repayments.
Limitations of the CPI as a measure of the rate of inflation
- It does not include housing costs, which are a significant item of expenditure for most households in the UK
- Some people do not have representative spending patterns and so might experience cost of living rises by more or less than the average shown by the CPI
- Attempts are made to take account of changes in the quality (eg mobile phone) or weight of goods (eg when chocolate bars are made smaller) but inevitably these adjustments may be imprecise.
- The list of 700 representative items is only changed once a year and so sudden changes in spending patterns are not reflected in the CPI.
- There are sampling issues. For example, households might not provide accurate information on their spending, such as understating the amount spent on alcohol. Also, some households might not respond to the survey.
What are the 3 main causes of inflation
Demand-pull inflation
Cost-push inflation
Growth of money supply
When does demand-pull inflation occur
When aggregate demand in the economy increases at a faster rate than aggregate supply. More people buying the same amount of goods means prices rise
When does cost-push inflation occur
When aggregate supply decreases, ie the total costs of production increase. This leads to a rise in the price level and a more general increase in costs across the econmy.
Causes of demand-pull inflation
- A decrease in interest rates
- A rise in the level of business and consumer confidence
- An increase in government spending
- Exports rising relative to imports
- Depreciation of the exchange rate (increasing demand for exports and reducing demand for imports)
Causes of cost-push inflation
- A rise in oil prices and/or raw material prices
- A fall in the exchange rate (making imports more expensive)
- A rise in taxes on businesses
- An increase in the minimum wage or in wages generally
- Increased regulations, eg environmental regulations, health and safety, that increase costs
What do monetarists believe
Some economists (monetarists) argue that the sole cause of inflation is increases in the money supply.
This is associated with an increase in aggregate demand in the economy.
Effects of inflation on consumers
- For those on fixed incomes (ie those whose wages do not increase in line with inflation - eg students and pensioners): inflation implies that their incomes would fall in real terms.
- For those with savings: if the rate of inflation is higher than the interest rate on savings, the real value of savings will decrease
- For those with loans or mortgages: if the rate of inflation us higher than the interest rate on loans, the real value of those loans will fall, making them more manageable for consumers.
Effects of inflation on firms
- Fall in exports: if the UK rate of inflation is higher than that of its main trading partners, the UK’s international competitiveness will fall. A firm’s exports became relatively expensive in foreign markets and imports from abroad seem cheap. This tends to worsen the balance of trade.
- Uncertainty: a high rate of inflation might make it difficult for firms to set budgets, which might result in a fall in investment.
- Lower profits: cost-push inflation is likely to cause a decrease in profits, which could result in lower investment. However, some inflation is desirable because it enables firms to increase revenues. In turn their profits could increase (especially if there is demand-pull inflation) and this might encourage them to invest.
- Impact on monetary policy: high inflation rates might cause the Monetary Policy Committee (MPC) to increase interest rates. This is known as tight monetary policy, and can have damaging effects, for example on investment by firms (it falls because the cost of borrowing increases).
Effects on inflation on the government
- Fall in the real value of the national debt: inflation would reduce the value of the debt owed by the government. Therefore, it becomes less of a burden.
- Increased inequality: inflation might make it more difficult for a government to reduce income inequality because those on fixed incomes will see a fall in the real value of their incomes
- A deterioration in the balance of trade: if inflation causes a fall in the country’s international competitiveness, its exports are likely to fall and imports to increase. This causes a deterioration in the trade balance.
Effects of inflation on workers
- For those in a weak bargaining position: if inflation is rising at a faster rate than wage increases, workers become progressively worse off, even if in nominal terms their wages have increased. However, if wages rise faster than inflation then real incomes rise.
- Unemployment: according to some economists there is a short-run trade-off between inflation and unemployment (the Phillips curve). A very low rate of inflation might imply a low level of demand in the economy and a high rate of unemployment.
What is the level of unemployment
The number of people in work
What is the employment rate
The number of people in work as a percentage of the working age population
What are the measures of unemployment
The Claimant Count: this is based on claimants of unemployment-related benefits, either from Jobseeker’s Allowance (JSA) or Universal Credit (UC).
The International Labour Organisation and the UK Labour Force Survey: The Labour Force Survey (LFS) is a survey of a sample of households. It asks people aged between 16 and 65 whether they have been out of work over the last 4 weeks and if they are ready to start within 2 weeks… The LFS uses standard international Labour Organisation (ILO) methods of measuring unemployment. Consequently, other countries use this method of measuring unemployment, allowing for international comparison.
What are the measures of unemployment
The Claimant Count: this is based on claimants of unemployment-related benefits, either from Jobseeker’s Allowance (JSA) or Universal Credit (UC).
The International Labour Organisation and the UK Labour Force Survey: The Labour Force Survey (LFS) is a survey of a sample of households. It asks people aged between 16 and 65 whether they have been out of work over the last 4 weeks and if they are ready to start within 2 weeks… The LFS uses standard international Labour Organisation (ILO) methods of measuring unemployment. Consequently, other countries use this method of measuring unemployment, allowing for international comparison.
What is the unemployment rate
The unemployment rate is the number of unemployed people as a percentage of the labour force.
What is the labour force
(Economically active population). It consists of the unemployed plus those paid or self-employment.
What is underemployment
The Office of National Statistics (ONS) measures underemployment as all those workers wanting to work more hours than they currently do and who are available to start in 2 weeks.
The OECD also includes in the definition of underemployment those people who are working in jobs where their skills are not adequately utilised, ie they are overqualified for the job that they are doing.
What does an increase in the employment rate cause
- Increased GDP, ie with higher employment, output in the economy is likely to increase
- Increased revenues and profits for firms
- Increased incomes, leading to an increase in the standard of living for households
- Improved skills (human capital - which is the knowledge and skills of a workforce that determine its productivity) of workers)
- Higher government taxation revenue - as more people pay tax and spend more (VAT and corporation also tend to rise when employment rises)
What does a decrease in the unemployment rate cause
Similar to the impacts of an increase in the employment rate but also include:
- Falling government spending on JSA, UC, and other out-of-work benefits
- Increased employment, which can have significant benefits because people who are out of the job market for a long period become increasingly unemployable
- The job market becoming less flexible (with fewer workers for employers to choose from)
Define economically inactive
People not in education, employment, or training, and who are not actively seeking work within the last 4 weeks and who are unavailable within the next 2 weeks
Impacts of an increase in the inactivity rate
- The productive capacity of the country will fall
- There may be more claims on state benefits
- The dependency ratio will increase (the number of inactive people that active and employed people are supporting, directly or indirectly).
However, if an increase in the activity rate is due to more people in higher education then this is likely in an increase in the skills of the future workforce
What are the causes/types of unemployment
Cyclical (or demand-deficient): lack of spending in the economy/recession means that people are out of work. You expect this type of unemployment in a recession.
Structural: where industries are in decline and workers’ skills are becoming obsolete (out of date).
Frictional: where people are between jobs.
Seasonal: where people are out of work for some periods of the year, for example ski instructors in the summer and surf instructors in the winter.
Classical or real wage inflexibility: where there are problems with the supply-side of labour, eg the minimum wage is too high and set above the equilibrium wage. Some economists (classical approach) argue that this is the cause of persistent unemployment in some countries.
Impact of migration on the economy
- If immigrants come into a country to fill vacancies then immigration leads to an increase in employment
- However, if immigrants are looking for work and either do not find it or displace other people from work then employment may be unchanged and unemployment might increase
- Migration might have implications for public finances - if the migrants find work then they will be paying taxes
- If immigrants come to a country to earn money to send home to their families (remittances) then this will adversely affect the current account of the balance of payments, at least in the short run.
What impacts will a highly skilled workforce have on an economy
- The workforce is more productive, so helping to increase the country’s rate of economic growth
- Earnings of highly skilled workers are likely to be higher than those of unskilled workers
- Highly skilled workers are less likely to be unemployed and have more stable and secure employment
- The above points mean that income inequality and poverty are likely to be lower than if there was a large proportion of unskilled workers in the economy
Effects of unemployment on consumers
- Decrease in living standards
- Loss of confidence leading to lower consumer spending
- Danger of mental illness if unemployed for a long time
- May result in lower house prices and a fall in personal wealth
Effect of unemployment on firms
- Easier to recruit new employees
- Less consumer spending so firms face falling sales, revenues, and profits
- Since there is surplus labour in the economy, firms might be able to hold wages down and, therefore, their costs
Effect of unemployment on workers
- Loss of skills - workers may not have up-to-date training
- Loss of income - welfare benefits are rarely as generous as paid employment
- Lower living standards because they have less income so quality of life falls
- Long-term unemployment may make it more difficult to get a job in the future
Effect of unemployment on governments and society
- Increased spending on welfare benefits, eg UC
- Less revenue from income tax and indirect taxes
- Opportunity cost - the goods and services that could have been produced by the unemployed workers
- Inequality may increase, perhaps resulting in more crime and/or political unrest
What is the balance of payments
A record of international payments over the course of a year
What is the current account
Records payments for transactions between countries in the present year.
Current account =
Balance of trade + the primary balance (investment income) + the secondary balance (current transfers)
Primary balance (investment income): earnings of foreign investments (interest, profits, and dividends) - payments made to foreigners
Secondary balance (current transfers): relates to transfers in the form of money or of goods and services, eg taxes and social security combinations
What is the balance of trade
The value of goods and services exported minus the value of goods and services imported
When does a current account surplus occur
When more money is flowing into the country than is flowing out… that a country’s current account is positive - ie that the combined value of the net trade balance, the net primary balance, and the net secondary balance is positive.
When does a current account deficit occur
When more money is flowing out of the country than is flowing in… that a country’s current account is negative - ie that the combined value of the net trade balance, the net primary balance, and the net secondary balance is negative.
Causes of a current account deficit
- The currency is too strong relative to other countries. For example, if the pound buys many euros then exports of goods and services from the UK will be relatively expensive. Meanwhile imports into the UK will be relatively cheap.
- There is a high rate of inflation relative to other countries
- There are high wage costs relative to other countries
- There is a high rate of economic growth in a country. People have higher incomes and tend to buy more imports from abroad.
Causes of a current account surplus
- The currency is too weak relative to other countries. For example, if the yuan is low against other currencies then China’s exports will be relatively cheap. In contrast, imports into China would be relatively expensive.
- There is a low rate of inflation relative to other countries
- There are low wage costs relative to other countries
- There is a low rate of economic growth in a country. People have less income to buy imports from abroad. In turn, this creates a strong incentive for firms in the country to export.
What is the relationship between current account imbalances and other macroeconomic objectives
If a country has a persistent current account deficit then it might imply that the country’s goods are uncompetitive, which could cause an increasing level of unemployment.
In turn, this may lead to a fall in the rate of economic growth. However, this may not be true if the deficit was caused by lower exports associated with a boom in the economy and high levels of consumer expenditure.
It could cause a fall in the country’s exchange rate against other currencies. In turn, this would cause an increase in import prices, which could be inflationary.
Describe the business cycle
- The rate of economic growth rarely stays constant over years.
- Instead, there may be some periods of rapid economic growth (a boom) when the rate of growth is higher than its long-term trend.
- On the other hand, there may be some periods of very slow economic growth (a slump) when the rate of growth is lower than its long-term trend. This could result in a recession (two consecutive quarters of negative economic growth), as occurred in many countries in 2008 and again in 2020.
- Between the boom and the slump there is a slowdown, and between the slump and the boom there is a recovery.
What is the conflict between inflation and unemployment
The short-run Phillips curve:
When the government tries to control the rate of inflation it is likely to try to reduce AD.
- Less spending will mean less upward pressure on prices
- The government might increase taxes or the MPC might increase rates
- the impact of these may reduce the rate of inflation but they will also mean a fall in AD.
- Firms may start laying off workers because they are unable to sell all their goods and services. As workers are laid off, incomes fall, and so the cycle continues.
- So, there appears to be a trade-off between the objective of controlling inflation and unemployment because in trying to control inflation, unemployment will rise.
This works in the other direction as well.
- If the government is trying to reduce unemployment it might start spending more on training workers or subsiding firms to take on more workers.
- This increased spending in the economy is likely to cause an increase in the rate of inflation
- This is because there is more money chasing the same amount of goods and services.
